Basics of Investing in Debt Mutual Fund

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A Debt Mutual Fund is an investment instrument that invests in a mix of debt or fixed income securities, such as, corporate bonds, money market securities, treasury bills or government securities depending on its mandate. Investors should choose Debt Mutual Funds as a tool to diversify their portfolio and should have a fair understanding of the risks involved.

Risk associated with Debt Mutual Fund

While investing in Debt MFs one should be aware that there are two major types of risks associated this instrument, viz. Interest rate risk: Risk of loss owing to changes in interest rates, best captured by the duration of the fund and Credit risk: Risk of loss owing to change in credit profile of an issuer that leads to either a downgrade or default.             
Identifying own risk profile        

Typically a Debt MF investor would want a risk profile that is the closest to a fixed deposit, hence they have to choose a debt fund that controls both interest rate and credit risk. While interest rate risk have always been identified as risk; since it is obviously visible as daily volatility in net asset value (NAV), credit risk has largely been called ‘accrual’ and the risk associated here has been underappreciated.

You often hear the debate of ‘duration v/s. accrual’, where ‘duration’ denotes funds that carry interest rate risk and ‘accrual’ denotes funds that carry credit risk. As interest rates turn more volatile, one hears the argument that investors should move from duration funds to accrual funds. This may not be consistent advice as  moving away from interest rate risk should not automatically mean the embracing of credit risk. Instead, if you do not like volatility associated with duration funds then move to funds with lower duration (short term funds for instance) while keeping credit quality constant. For example, consider an investor in a dynamic bond fund running a combination of AAA and government bonds, but of higher maturity and wishes to curb the interest rate risk. The right step would be to move to a short-term fund which has lower maturity but has a similar credit risk, i.e. AAA and government bonds. Had the investor moved to credit risk funds that invest predominantly in AA and below, the investor is only switching one risk for another and not really reducing the net risk in the portfolio.

Building your portfolio

As most Debt investors are conservative, majority of the allocations should be to products most likely to have conservative risk profiles that control both duration and credit risks. A good framework to follow is to allocate your funds into three buckets – Liquidity, Core and Satellite. The Liquidity bucket is for very short term parking of surplus or as your emergency corpus and so will only house products that have high liquidity, for redeeming on short notice. The Core bucket is true to label fixed income products that aim to replicate the safety of fixed deposit while providing slightly better returns through controlled duration and credit risks. Full AAA funds in the low duration / short term / medium term / corporate bond / Banking PSU categories should fulfill this criterion largely. Such funds should form the majority of allocation for conservative investors.  Our offering, IDFC Bond Fund – Short Term Plan, fits well into the core portfolio offering with a constrained duration and constrained credit strategy.

The Satellite bucket should house most of the riskiest Fixed Income products pursuing ‘alpha’ oriented strategies. These could be through either funds that take interest rate risk (for instance dynamic bond funds) or those that take credit risk (credit risk funds) or both. A lot of discussion on credit revolves around quality of manager and depth of research process. What is equally important, however, is to ask, if the nature of risk being taken consistent with the vehicle being used to take the risk? More specifically, are open ended mutual funds the appropriate vehicle to take on such positions?

So long as such allocations are kept to the margin (as decided basis investor’s risk appetite), then one needn’t do tactical reallocations from time to time. However, do note that such tactical reallocations are also tax inefficient or may be subject to exit loads.


Investors should be aware of individual risk profile. Assuming debt investments are made first for conservatism, a majority of allocations should be to full AAA funds e.g. IDFC Bond Fund – Short Term Plan. It is also important to note that credit is a risk just as interest rates are. It can lead to both positive as well as negative outcomes. The key is to allocate to both credit and duration in the Satellite bucket and not in the Core bucket.   



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